NZX Clearing, the central
counterparty that settles all NZX on-market transactions,
determined its current approach was not sustainable or
economically efficient to support the continued growth of
the derivatives market. The fund's introduction follows a
12-month consultation and engagement period.

The NZX
dairy derivatives market was launched in 2010 to provide
risk management tools for anyone with price exposure to the
global dairy market. In the year to the end of October,
total dairy derivatives lots traded - including futures and
options - was 283,484, up from 29,035 lots in the same
period in 2013.

The new default fund will require
contributions from all dairy derivatives clearing
participants and builds on a series of initiatives the NZX
has carried out during the past year. These include
increasing trading functionality and extending market hours
to meet customer demand in Asia and Europe.

"The
mutualised default fund is an essential enhancement to NZX's
risk management framework and will support the growth of our
global derivatives market. Core to the delivery of the fund
is efficient utilisation of capital when providing market
protection, which in turn supports market growth," said
Benjamin Phillips, NZX head of markets development.

Under
the previous system, cash or assets available to NZX
Clearing (NZC) in the event of a derivatives clearing
participant default included collateral provided by the
defaulting participant to cover the margin requirement and
risk capital of $20 million provided by NZX.

This meant
NZX Clearing was providing more than 66 percent of the
required capital to meet potential losses arising from a
clearing participant’s default.

"Continuation of this
structure imposes high and uneconomical costs on NZC to meet
the growth of the derivatives market and the associated
derivatives clearing participant risk related to these
exposures," it said.

Under a default fund structure,
rather than the cost of the default being carried by
clearing participants individually, the pre-funding
obligation for a single default is shared across all
clearing participants contributing to the fund.

In
addition, the contribution of each clearing participant to
the default fund is calculated according to its market share
of the risk exposures, the NZX said.

NZX Clearing will
determine the default fund size by performing a stress test
on the largest derivatives clearing participant’s net
derivatives exposures. The total default fund requirement is
derived from the highest daily stress losses if that
participant were to default under the specified stress
scenario.

Derivatives participants who are creating the
greatest risk to the market will make the greatest
contributions to the default fund.

Based on the assumption
of a 75 percent growth in derivatives trading volume, NZX
Clearing’s default capital forecasting indicates that the
largest derivatives participant's uncovered stress losses
would be $27.6 million and $33.4 million for 2018 and 2019
respectively.

The forecast default fund ranges from $17.6
million to $23.4 million for 2018 and 2019. The largest
derivatives participant, which, on forecast, has a market
share of 32 percent and 25 percent for 2018 and 2019
respectively, would be required to contribute approximately
$5.3 million and $8.4 million, it said.

There will be no
cap on the size of the fund but it will grow organically
based on the required amount of default capital.

The
original purpose of the cap on the default fund was to fix
NZX Clearing’s “skin in the game” contribution to a
minimum of 25 percent of the overall default fund size.

As the default capital requirement grows to a point that
NZX’s contribution may become less than 25 percent of the
size of the default capital requirement, NZX Clearing will
need to re-evaluate how default capital for the market
should be provided, including its own skin in the game and
the default fund, it said.

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